F ISCAL POLICY AND BUSINESS CYCLES VOLATILITY

A line of study focuses on the role of fiscal policy in influencing the volatility of business cycles. A common approach is to measure either discretionary fiscal

policy, or the cyclical budget balance. From this approach one can investigate if fiscal policy in EMU acts countercyclical or procyclical,⁷ and thus if the fiscal policy acts smoothing on business cycle volatility or not. Sovereign debt is an important issue as regards the financing of fiscal spending, and has therefore been explored in literature on fiscal policy.

4.2.1 Discretionary fiscal policy

Fatás and Mihov (2000) conduct an empirical study of the effects of fiscal policy by looking into the dynamic effects of discretionary changes in fiscal policy.

Their sample consists of data from 20 OECD economies during the period 1960-1997, and the authors argue that their estimates should provide a benchmark for the discussion of national fiscal policies in eurozone countries. Their goal is to study how the economy reacts to various shifts in discretionary fiscal policy by using different methods of identification of discretionary fiscal policy shocks. The authors find strong effects of changes in fiscal policy on economic activity.

Gali and Perrotti (2003) investigate if the Maastricht criteria and the SGP have weakened the ability of EU governments to conduct a stabilizing fiscal policy and to provide an adequate level of public infrastructure. They estimate fiscal rules for the discretionary budget deficit over the period 1980-2002, and divide the time series in two periods: before and after the Maastricht treaty (1980-1991 and 1992-2002). Gali and Perotti identify discretionary policy by controlling for the cyclical component. Thus, they argue the discretionary policy to be the fiscal stance. By dividing the fiscal stance in an endogenous and an exogenous component, the authors distinguish between structural and random spending and revenues. Their main finding is that discretionary policy in EMU has become more countercyclical over time, and this is a trend that also concerns other industrialized countries.

Sebastian Dullien (2007) analyzes to what degree fiscal policy functions as a stabilizing tool in the EMU, and how this could be improved. The sample includes 12 EMU countries over the time period 1991-2006 and four OECD countries.

Dullien divides the time series in two periods: before and after the introduction of EMU in 1999 (1991-1998 and 1999-2006). Dullien’s results on discretionary policy differ from Gali and Perotti, as Dullien finds discretionary policy to be acyclical and procyclical, depending on the country. He argues that discretionary fiscal policy suffers from information problems due to the fact that macroeconomic shocks are hard to predict as aggregated data are published six weeks after the end of a quarter.

Candelon et al. (2007) also come to a different conclusion than Gali and Perotti.

Candelon et al. analyze the stability of fiscal rules for EMU countries in the time-periods before and after the Maastricht treaty. Fiscal policy is divided into discretionary and non-discretionary fiscal policy. The sample includes the years 1980-2004. The authors find that discretionary policy remains procyclical after 1992. Candelon et al. argue that the fiscal arrangements induced by EMU have provided less room for effective discretionary policy. Another finding is that fiscal rules differ between large and small countries. Large countries follow a procyclical discretionary policy.

Dinu et al. (2011) use a reaction function model of fiscal policy to study the behavior of governments in the eurozone countries. They include the first twelve member states of the EMU in the period 1990-2009. They study three models, namely the budget balance model, the structural budget balance model and the cyclical budget balance model. Their estimates show that the variation of the actual budget balance was acyclical in the sample period, while the variation of the structural budget balance, or the discretionary fiscal policy, was counter-cyclical. Thus, they claim that discretionary fiscal policy meets the stability condition, meaning that the years with expansionary policies were alternated with years of restrictive policies. However, their results show that the governments’

response to the economy’s cyclical fluctuations decreased along with adoption of the euro as a single currency because of the restrictions introduced by the Stability and Growth Pact.

4.2.2 Automatic stabilizers

Van den Noord (2000) investigates the role and the size of automatic fiscal stabilizers. He defines automatic stabilizers as components of government budgets

that are affected by the macroeconomic situation in ways that operate to smooth the business cycle. ‘Automatic stabilizers’ is another name for the cyclical component of the budget balance. He identifies the components as taxes and unemployment insurance. In times of recession fewer taxes will be collected and more unemployment insurance will be paid to support private incomes and stimulate the aggregated demand. In times of expansions more taxes will be collected and payments of unemployment insurance will decrease to counteract the aggregated demand. Van den Noord (2000, p. 4) states that the stabilizing property will be stronger if the tax system is more progressive. He points to the existence of other automatic stabilization mechanisms (such as financial markets), and calls the aforementioned automatic stabilizers for automatic fiscal stabilizers.

Van den Noord (2000) underlines three cautions in the workings of automatic stabilizers. The author argues that if governments allow automatic stabilizers to work fully in downswings, but fail to resist the temptation to spend cyclical revenue increases during an upswing, the stabilizers may lead to bias towards weak structural budget positions. The result may be rises in public indebtedness during periods of cyclical weaknesses that are not subsequently reversed when activity recovers. This could lead to higher interest rates and will also require reduction in spending or a tax raise. Another caution is that automatic stabilizers respond to structural changes in the economic situation. This may lead to a decline in the country’s growth potential, which may lead to a scenario in which automatic stabilizers undermine public finance positions. The final caution is that the tax and insurance systems serve other objectives as income security and redistribution. These systems may delay necessary adjustments in the wake of a recession (van den Nord, 2000, p. 5). Van den Noord assesses to what degree automatic stabilizers operate to smooth the business cycle in individual OECD countries. He finds that automatic fiscal stabilizers have generally reduced cyclical volatility in the 1990s. Further, he finds that some countries have undertaken fiscal consolidation to improve fiscal stabilizers. The government has then taken discretionary actions that have reduced or off-set the effect of automatic fiscal stabilizers.

as the size of government, and find that large governments are associated with less volatile business cycles. Disaggregating fiscal policy into different components, the authors find that changes in taxes, transfers and government employment are the most effective tools of fiscal policy when it comes to smoothing the business cycle.

In his analysis on the degree fiscal policy functions as a stabilizing tool in the EMU, Dullien (2007) examines the role of automatic stabilizers as a part of fiscal policy (explained in chapter 4.2.1). Dullien states through econometric analyses that sizable automatic stabilizers exist in EMU. The econometric calculations shows that discretionary fiscal policy has counteracted the automatic stabilizers so that the overall fiscal policy has been acyclical or pro-cyclical. Dullien proposes an EMU-wide unemployment scheme for further stabilization in the euro area.

The study of Dinu et al. (2011) also confirms the role of the automatic stabilizers in stabilizing the cyclical fluctuations within the eurozone.

4.2.3 Sovereign debt accumulation

There are two ways of financing fiscal spending, either by borrowing money or through taxation (for instance via automatic stabilizers). The focus on financing sources has increased as the euro area is experiencing a sovereign debt⁸ crisis.

Several authors have examined if one of the financing sources is more appropriate than the other. The phenomenon mostly studied is perhaps the well known Ricardian equivalence theorem, stating that the outcome of financing government spending either through taxes or debt will in the long term accrue equal costs.⁹ Leith and von Thadden (2006) discuss the design of simple monetary and fiscal policy-rules consistence with determinate equilibrium dynamics. By adding an assumption of actors’ death in their model, and thus removing the presence of Ricardian equivalence, government debt turns into a relevant state variable which they claim needs to be accounted for in the analysis of equilibrium dynamics (Leith & von Thadden, 2006).

8 Sovereign debt is the debt of the country, or debt of private consumers that is guaranteed by the country’s government.

9This theory is criticized based on the assumption of perfect capital mobility, zero probability of death for the consumers, and no savings nor borrowing constraints on consumers, and that the consumers are willing to save for future taxes.

Dullien (2007) points to modern micro-founded models that have provided new rationale for the effectiveness of fiscal policies, including interest payments on sovereign debt. The author states that a number of models show that fiscal stabilization policy can be effective if households are liquidity-constrained and have limited access to unsecured loans. Thus, he argues that there exists empirical indication that the Ricardian equivalence theorem does not hold in its absolute form. In his analysis, Dullien removes the workings of interest payments and automatic stabilizers, and use the cyclically adjusted primary budget balance to find the discretionary policy. Dullien includes a measure of debt in his equation.

By doing this he claims to include the debt level and thus policy makers’ concern about the overall level of public debt. He further argues that a cost of stabilization is that governments increase their debt in order to meet the Maastricht fiscal deficit criteria. Dullien claims the cost of government debt is to be borne by each government, which should weight its own benefits from stabilization against the costs of such a policy. He argues that rationally the government will decide for a degree of stabilization which is significantly lower than it would be optimal for the currency union as a whole.

Interest payments are the result of the accrued sovereign debt and creditworthiness amongst creditors and other market actors. The sovereign debt trends detected in the last three decades suggest that the debt-to-GDP ratio has been increasing at a non-sustainable level for member states in the EMU (Gali & Perotti, 2003), (Lynn, 2011). The accrual of sovereign debt will in worst case scenario accumulate in a default if the country is not able to pay the interests. Hattenhouer (2000), in Gianviti et al. (2010), links accrual of sovereign debt to political judgement. Hattenhouer (2000) explains that the main asset of a sovereign debtor is its power and capacity to tax, which is an intangible asset in nature. Further, he argues that the economic value of this intangible asset depends on the degree of hardship a country’s citizens are willing to bear in order to service its debt and on the government’s administrative capacity to raise revenues. It has been argued that highly indebted countries benefit from euro area membership, in terms of lower interest rates paid on the countries’ public debt because the monetary union makes the commitment to low inflation more credible (Gianviti, Kruger, Pisani-Ferry, Sapir, &

currencies,¹⁰ sovereign default in a monetary union is more challenging because member states lack monetary policy autonomy. Gianviti et al. (2010) argue that by closing the inflation channel, monetary union leaves a country with only three ways out of a situation of excessive debt: severe and harmful fiscal retrenchment, default, or being bailed out by the other members of the monetary union. Gali and Perotti (2003) argue that the sovereign debt interest payments are largely outside the control of the incumbent fiscal authorities and is such not an expression of the current fiscal stance, but on earlier fiscal stances on accrual of sovereign debt. As such, they argue that interest payments are part of the discretionary policy which they find to influence business cycle volatility.